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  • Writer's pictureRobert von Hoffmann

VH Standard Merger Arb Fund - Monthly Letter (February '24)

Updated: Feb 22


VH Standard AM - Monthly Letter (1-24)
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Green grass growing on mountainside during winter
The beginning of a new spring.

Deals mentioned in this letter: SAVE, IRBT


You’d be hard pressed to find a better indicator of how we felt about the current investment opportunity in merger arbitrage than how we allocate our own money – similar to management with a stake in a company buying back shares from other shareholders. So, on Feb 1, we decided to invest an additional $100k from our own balance sheet into the fund because we believe in the attractiveness of the current merger arbitrage environment following a difficult month for most. As of January 31st, the effective spread across the universe of merger arbitrage is 14.3%,1 and the implied probability of close of these deals has dropped below 80%1. Not only does the implied probability of close not match up with historical data, but the yield you’re getting to take that risk is 9%+ over the 3-month T-bill rate (our risk-free rate). We typically aim to get between 3 percent to 5 percent above that risk-free rate, so this 9% is about as attractive as it gets to us, and not something that happens often!


We think the reason for this attractive environment in M&A deals involves a few factors: 1) mainly, fear of regulators on the back of the two blown deals in Spirit Airlines and iRobot, 2) de-risking all other positions to adjust for this market change, 3) potentially, other managers closing up shop and liquidating their positions across their portfolios, 4) interest rates to stay higher for longer, affecting spreads, 5) leverage costs affecting the over-levered portfolios with deteriorating profitability.


We think this environment is likely to sustain in the months ahead, but, as deals close (and they will), we are happy to accept elevated compensation in our “marketplace” for M&A transactions. We see this akin to an insurance marketplace where insurers once chasing volume are now absent, allowing us to command excessive premiums for our portfolio of deals.


RESULTS

During the first month of the year, our gross returns were negative at (1.66)% with our net return at (1.74)% for the month after fees. In January, we completed one deal. This brings our total completed deals to 45 since our inception in July ‘23. Most notably for the month, two deals (Spirit Airlines & iRobot) that we discussed in our November letter were officially blocked, as Spirit Airlines (SAVE) and JetBlue lost their court case against the Department of Justice (DoJ) for violation of the Clayton Act of 1914. In the second deal, iRobot and Amazon agreed to terminate their transaction on January 29th because the European Commission intended to block the transaction on February 14th.


IROBOT - AMAZON (IRBT)

Around the middle of January, negative rumors surrounding the iRobot deal with Amazon began to surface. Amazon had decided not to offer any remedies to the EU and headlines suggested that the deal may be headed for trouble with a closed-door meeting potentially scheduled on the FTC’s calendar for January 25th – See Article Here. For us, this was worth concern, as we were already aware of the difficulty Amazon was having with the European Commission, outlined in the EC’s Statement of Objections at the end of November – See Article Here. Additionally, the deal already needed restructuring to allow iRobot to secure an additional $200 million facility to fund ongoing operations. For us, the EU approval was the biggest hurdle for the transaction, as we believe the European Commission wields more power to block transactions than the FTC, especially on these types of deals, so not offering remedies was the biggest cause for concern.


On top of these transaction related concerns, we had fears about iRobot as a standalone company. We conservatively marked our downside for IRBT shares landing somewhere between $5/share and $10/share in the case of a deal break. For purposes of measuring our position sizing, we used $5 – iRobot has a questionable balance sheet, deteriorating fundamentals on the topline, and new competitors taking market share.


As a quick note, whenever a deal gets restructured after the DMA has been signed, there’s a less likelihood that this deal will be completed. This is more a symptom of problems, rather than an underlying cause for concern.


With all these negatives built up against the transaction, we began considering our risk exposure to this transaction. On January 10th, the news broke that Amazon would not be offering remedies to European antitrust regulators. For us, this became a very low probability deal on that news and we began looking to sell our position down immediately. Over the next week, we looked to sell around $32.50, but were unable to find a buyer at that price. In hindsight, we felt we had additional time to be patient with a deadline of February 14th for a decision from the EU. Unfortunately, within a few days, the shares for IRBT began selling off, causing more concern for us - we sold half of our shares at $26/share because of this on January 18th. Later that night, and signaled by the market earlier that day, more news came out that the European Commission intended to block the deal. To us, the deal was now dead, so we sold the majority of the shares we still held that night for $14 a share, with the remaining shares sold in the morning after at $16.70 a share. Overall, we realized a loss of approximately a (1.15)% contribution to the portfolio – not ideal, but not outside of what we’re expecting from time to time in this merger arbitrage strategy.


It's a good thing we were conservative with our downside on this transaction. The current price for IRBT was $12.35 per share, as of February 16, 2023.


SPIRIT AIRLINES (SAVE)

The other transaction that broke during the month of January was the Spirit Airlines deal with JetBlue. For us, we typically don’t like transactions in industries that could be considered public utilities for the greater good. It’s easy to make this case for airlines, which were once regulated as a public utility until the Airline Deregulation Act of 1978, and for that reason we were hesitant to taking much risk in this transaction. Additionally, you had the 6th largest US airline merging with the 7th largest US airline, by market share, to create the 5th largest airline and a new competitor to the big 4 (American, Delta, Southwest, United). This oligopoly market structure is a negative statistically for us, on top of the headline risk, political motivations, and shaky-at-best standalone operations in a questionably profitable business model.


In the end, we limited our exposure from the beginning, due to our assessment of the transaction risk, and realized a loss of approximately a (0.40)% contribution to the portfolio – again, not ideal, but still well below our stated limits on how much risk we’re willing to take.


The current price for SAVE was $6.62 per share, as of February 16, 2023.


We talked about these two transactions in a previous letter, so this was not something that came out of the blue for us. We had been aware of the troubles these companies might have in completing the transaction; however, it’s our job to take measured risk and to manage that risk.


Thank you for reading. We look forward to continuing to build this portfolio. If you’d like to have a conversation, feel free to reach out.


“Great things are done by a series of small things brought together.” – Van Gogh

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